Will the Bank of England pull out all the stops?

Go all out or save some for later? That is the question the Bank of England (BoE) will face on Thursday 4 August.

03/08/2016

Harvinder Gill

Economist

If the economic outlook over the forecast horizon is highly uncertain with clear downside risks, some policymakers suggest following a “risk management” approach to setting monetary policy (i.e. going all out).

Others suggest waiting for clearer signals that downside scenarios have materialised before acting (i.e. saving some for later).

Risk management defined

Risk management, in the context of monetary policy, can be defined as a policy that takes into “account the dispersion of shocks around their means” (Evans, Fisher, Gourio and Krane, 2015).

So, policy is set taking into account the probability of a more complete range of events, rather than just setting policy for the most likely outcome in the central bank’s forecast horizon.

The net effect of this in the current environment has been to keep policy looser than historical relationships suggest is required.

Running out of options

Looking at monetary policy across developed markets, it could be argued the issue of risk management is now of greater importance.

As they attempt to stimulate demand, central bankers are having to use alternative tools to force rates lower as policy is constrained by the zero lower bound1 (ZLB).

It is also argued that with greater uncertainty about the effectiveness of these unconventional tools in easing policy, more should be done to combat downside risks than would be done to neutralise equivalent upside risks.

The corollary of this is that in times of uncertainty where tangible tail risks exist and where rates are already low, more substantial easing should be undertaken than would be expected if rates were higher.

Costs are well-known

In effect, by applying the risk management school of thought, central banks insure themselves against severe losses of output by keeping policy looser than their baseline forecast may suggest is warranted.

While the benefits of looser policy at low rates become more ambiguous (which is the reason risk management suggests easing more than usual), the costs are not.

These can come in the form of less money being earned on savings, forcing some to reduce spending in order to save more.

A lower discount rate (the assumed investment return used in a present value calculation of assets) also increases liabilities for pension and insurance companies, with more capital needed to match liabilities. Banks also face difficulties, with lower profit margins often cited as an issue.

Higher inflation could also be a consequence of “lower for longer” interest rates, but with the current fear of low inflation being embedded into consumers’ expectations, it has been deemed a price worth paying by many.

Counterintuitive?

However, this central bank loss aversion argument may seem counterintuitive to an extent.

By easing policy in an aggressive manner when rates are already low, some argue the short-term ZLB issue in fact becomes more acute.

Put simply, cutting rates aggressively enough will eventually lead to a point where you can cut no further. And it as at this exact point you surely face the problem that you were trying to avoid.

To this extent, some suggest each available further rate cut should be “saved for a rainy day”, where negative outcomes are known with greater certainty and hard data confirming such a slowdown is available.

Pros and cons

There are obvious pros and cons to both monetary policy approaches. We will have to wait and see which route the Bank of England deems most appropriate on Thursday.

1. A macroeconomic problem faced by central banks who have already taken interest rates to at or below zero, and are limited in their ability to cut any further.↩

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